“It’s all relative, I suppose. You think you know love, you think you know real pain, but you don’t. You don’t know anything.” – Jenny Han
In Part 1 of this 2-part series, we reviewed the extreme lack of consistent outperformance among domestic equity funds. In this edition, the plan is to see if the same holds true within alternative investments or if we can uncover any segments where consistent outperformance is “a thing.”
Autocorrelation
Looking back on the CAIA (Chartered Alternative Investment Analyst) curriculum, one phenomenon we didn’t have to worry about in the liquid/public investment realm, but which does come up in Alts, is that of autocorrelation.
In Part 1, we examined two separate timeframes and then whether a given manager could remain at the top of its peer group (e.g., the top half, quartile, decile) in each of those periods. But another way to examine performance persistence is to consider it from a correlation perspective: i.e., are subsequent periods of performance statistically related to one another, or – phrased differently – are the returns correlated with one another?
Now, keep in mind that this adds a twist to our discussion because it is not about outperformance. Instead, the returns could exhibit a persistence that is either positive or negative – i.e., positive returns tending to follow positive returns or negative returns tending to follow negative returns. So it’s more like looking for trends than outperformance.
When we look at illiquid assets, which are slow-moving beasts, we almost can’t escape that returns will have performance persistence (either in a positive or negative direction). That means the returns will inherently be correlated, and THAT is what’s known as autocorrelation (aka serial correlation). It’s like automatic correlation because the markets and pricing mechanisms move so slowly.
A good example of this is house prices. If you follow local real estate in your area, do prices tend to fluctuate wildly up and down from month to month? Or (far more likely), do they tend to go through long periods where prices trend steadily upwards or downwards? That’s natural because of how real estate markets work. People pay a little bit more for a given house, and that sale adjusts the market upward (we’ve anecdotally seen pretty extreme examples of this playing out all over the country lately). Then, at some point, no one is willing to pay higher prices, and the trend reverses for a while, with prices edging incrementally downward. It’s very different than highly liquid equity markets, where stocks can easily be up or down from one day to the next.
The reason autocorrelation is important is that it’s a potential pitfall: it can lead us to believe that a fund in some less-liquid market segments (e.g., real estate) has positive (or negative) performance persistence, when, in reality, it’s just due to the natural tendencies of the markets themselves.
Persistence or Consistence?
The above is helpful to know, but it’s sort of ancillary to our primary mission today. I think it also brings about the need for a simple clarification: “performance persistence” can be in a positive or negative direction, and it only compares one manager’s (or asset’s) current returns to its previous returns and whether those returns are correlated.
What we’re really looking for is the “consistent outperformance” of a manager vs. its peers. That could mean very positive returns in good times or less-negative returns in challenging markets; it’s all relative and has nothing to do with correlation.
Hedge Funds: I’m Going With “Yes”
As pointed out in Alternative Investments (CAIA Level I, third edition), certain studies have shown that performance persistence doesn’t exist among hedge fund managers. However, there may be strong evidence for the persistence of hedge-fund manager skill when adjusting for risk. Interpretation: some hedge funds are consistently better at generating good returns while managing volatility from year to year (aka “skill”). They also point out that the conclusions are murky because it depends on how the risk adjustment is implemented, and the hope is that such modeling will improve to have utility in the future.
Anecdotally speaking, there are undeniable examples of hedge funds that have stood out as the best of the best. We covered Renaissance Technologies in this previous alt.Blend, but others have continued to post impressive returns through various market environments, despite attracting more capital and growing significantly. When you examine these managers in close detail, it becomes clear that their strength is their process, and that’s what creates consistency. In some cases, they are simply in an entirely different league than their competitors.
Venture Capital: Success Breeds Success
As this Yale Insights article points out, VC is a clear exception to the lack of consistent outperformance. The top managers tend to stay atop the leaderboard year in and year out, and there is a good explanation for this: they get access to the best deal flow. They can invest in the best deals that everyone wants to, but few can. They also have the scale to make later-stage and larger investments that involve less uncertainty than early startups (in which smaller/unknown VC managers may be limited to investing). VC is a very “hit or miss” strategy – with a few wildly successful investments making up for many total failures – and their access allows them to have more “hits” and fewer “misses.”
A reason the biggest and best VC firms get access to the most sought-after deals is that, well, they’re the biggest and best VC firms. Entrepreneurs want to be associated with them because of their reputation, as this attracts additional high-quality investors and talent to grow their companies. Thus, it’s a self-fulfilling prophecy.
That all being said, generally speaking, VC may not be a good deal for investors (LPs), as pointed out in The New Reality of Venture Capital. There are hundreds of VC managers, but it may really only make sense (from a risk/return standpoint) to invest with the best of the best, and most LPs “don’t have a snowball’s chance in hell of getting into one of those top funds.”
Private Equity: Process is Key, So Beware
First, some clarification: when we say “private equity,” it can refer to a wide range of strategies and structures. However, the “traditional” meaning of private equity is that of buyout funds – i.e., a private equity fund that purchases 50% or more (and thus, a controlling interest) of various companies, typically using a substantial amount of leverage via borrowing (similar to the idea of you taking out a mortgage to buy a house). These transactions are also called leveraged buyouts, or LBOs.
For a different perspective, this 2020 Institutional Investor article cites “little or no evidence of persistence, for buyouts” after examining 893 buyout funds launched between 1984 and 2014. The study added some pragmatism by using information investors would have had available to them when a given fund was being raised. You may recall from a past alt.Blend (Framing the Solution) that PE managers typically raise funds in succession.
Once a fund (let’s call it “Fund I”) has gone through its capital-raise period and moves into its investment phase, it will then close to new investors. At that time, the manager will begin to raise Fund II. Therefore, the Fund II investors can only see the early-stage performance of Fund I when they commit to Fund II. BUT, Fund I still has 5+ years left in its life before the final results are in. The article implies that the partial-life fund performance is not helpful as a predictor for the performance of the following fund. Managers will try to raise money when Fund I is performing well to play on investors’ emotions, who can be “tricked” into believing Fund II’s performance will have anything to do with that partial Fund I performance. Make sense?
In another study performed by Pantheon and outlined in this article, the findings are a bit different. Unlike mutual funds (which we covered in Part 1 of this series), “There is something stickier in private equity that is probably linked to the way firms create value that endows the track record with more persistence than in other asset classes.” The difference here is they are looking at the track record of completed funds (i.e., the final performance of Fund I, the final performance of Fund II, etc.) vs. the above partial performance.
The article goes on to point out some critical nuances. We, as analysts, have to do our best to: a) avoid managers who had bouts of luck (“lucky deals and luck timing”) that made performance appear better than it should have, and b) ensure that there is a strong succession plan in place when any key personnel of a fund departs. Otherwise, the fund will lack vital consistency on which we are relying.
In essence – as we’ve covered before and we’ll cover again – the “edge” of these best-in-class managers comes down to their process. In PE, the managers go into these companies and completely rewire them: restructuring the balance sheet, reworking management/staff, culture, making upgrades, etc. It makes intuitive sense that some PE firms are better at these company improvements than others because of their resources and experience; thus, there’s a better chance of replicating success. The degree of influence PE managers can have on their portfolio of companies is FAR greater than that of a mutual fund manager selecting stocks. Thus, in the private equity world, persistence is a more common phenomenon.
Other Extrapolations
Given the elements that lend themselves to the persistent outperformance that exists in VC and PE, there are other areas where I’d feel comfortable in assuming persistence also exists.
One is private real estate, a subset of private equity; instead of buying businesses, you’re buying properties (and sometimes it’s a property specific to a particular business that also needs to be operated, so even more nuanced and complex). The best managers source off-market deals through their networks. They may have relationships with specialized operators in local markets for various property types (e.g., multi-family vs. senior care vs. self-storage, etc.), and their experience allows them to buy underperforming assets at a discount. In addition, they know how to underwrite deals conservatively to achieve desired returns, make targeted improvements, increase occupancy, and create value.
Another is private credit Access to deal-flow, and strict underwriting methods are vital. The best managers see many deals and say “no” to the vast majority of them. It’s a labor-intensive, specialized end-to-end process, including sourcing, underwriting, structuring, approval, and monitoring. Depending on which parts of the market they “play” in, they also get called upon by the best PE firms who need to borrow money, they have broad networks of lenders to piece together solutions for a given project (leveraged buyout, real estate project, etc.), and they structure deal terms so that capital is protected. If done correctly, debt holders can benefit, even in situations where equity is completely wiped out.
Unlike traditional asset classes, performance persistence is more prevalent in specific segments of Alts. As we’ve seen, it’s not related to one particular thing, but a combination of everything all working together: better people, experience, resources, and processes, combined with the degree of control that exists in private markets, that consistently drive better outcomes for investors. It’s all relative.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
